A risky financing method that helped get Canada’s cannabis industry off the ground could soon turn into a millstone of rapidly maturing debt around the necks of under-performing pot companies.

Hundreds of millions of dollars of cannabis company debt, in the form of a fundraising tool called a convertible debenture, is slated to come due over the next three years. Publicly traded firms whose share prices have stagnated or dropped will be forced to repay this debt, despite having little revenue and a limited ability to refinance.

“I think most people have forgotten about those raises, they were done a year ago or more and nobody really talks about them anymore. A lot of people seem to have forgotten what the terms were,” said Greg Taylor, a portfolio manager at Purpose Investments in Toronto who handles the firm’s marijuana holdings.

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Unable to raise money using traditional debt or equity, public cannabis companies have relied heavily on convertible debentures (convertibles), a kind of unsecured bond that can be converted into shares at a predetermined price.

In the three years leading up to the legalization of recreational marijuana, the many small cannabis companies listed on the Canadian Securities Exchange raised a total of $352-million via 36 convertible debt financing deals, CSE data shows. Larger licensed cannabis producers (LPs) listed on the Toronto Stock Exchange, the TSX Venture Exchange and major U.S. exchanges, also gorged on convertible debt; Aurora Cannabis Inc., raised US$345-million using convertibles in January, while Tilray Inc. raised US$435-million with convertibles in October – to name just two recent examples.

Convertibles are favoured by investors in high-risk, early stage companies. If a company’s stock goes up, the investor can make money by converting the debentures and selling the resulting shares, pocketing the difference between the conversion price and the market price; if the company’s share price declines, the investor can treat the debenture like a bond, earning interest payments and eventually recouping the principal.

“There is a lot of convertible debt out there in the cannabis space and if they’re not going to be able to convert that to equity, there is just going to be high-interest debt that is going to have to be dealt with,” Mr. Taylor said.

Companies can force debentures to convert, if their shares trade over a certain price for a certain number of consecutive days, thereby removing a significant liability from their balance sheet. The large LPs who have seen their share prices skyrocket have had little difficulty doing this. The downside to a company choosing to convert is potential dilution to existing shareholders from all the new stock that gets issued.

It is the small and mid-sized LPs that could be in trouble, Mr. Taylor said. Many raised money using convertibles at the peak of the pre-legalization stock market excitement, and have since watched their share prices decline. They are now trading well below the price needed to convert the debentures.

In January, 2018, for instance, Auxly Cannabis Group Inc. (formerly Cannabis Wheaton Income Corp.) raised $100-million using convertibles. These debentures, which carry a 6-per-cent interest rate, come due next January. The conversion price is $1.55, and Auxly can force the debentures to convert if its shares trade above $3.10 for 10 consecutive days. Auxly stock is currently trading around $0.80; it hasn’t traded above $1.55 since last May.

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VIVO Cannabis Inc. (formerly ABcann Global Corp) is another example. VIVO raised $34.5-million in February, 2018, using convertibles that bear 6-per-cent interest and come due in February, 2021. These debentures convert at $4 and VIVO shares are currently trading around $1.

Both companies, and others like them, have successfully converted debentures in the past. But that was in the midst of a rising market, when retail investor excitement was pushing up all cannabis stocks ahead of recreational legalization.

“When the space, or stock has continued excitement, convertible debt is great,” said a hedge fund manager involved in convertible deals with cannabis companies, who requested anonymity because he was not authorized to speak publicly. “When stocks stop going up or things start running on the spot … and the companies don’t have the ability to pay it back, that’s when things will get ugly.”

LPs that are unable to convert their debentures could have a hard time managing the debt when it starts coming due.

“Companies with near-term maturing convertible debentures often face difficulties in refinancing their tranche of debt as there are often no material unencumbered assets for a senior secured lender to lend against. Asset sales and additional capital are often the first claim for senior debt tranches,” noted a 2014 report from Deloitte entitled ‘How to avoid the death spiral of converts: The Canadian convertible debentures market.’

The problem can also compound as the maturity date approaches, the report’s authors note: “Companies with near-term maturing convertible debentures will often see a depression in their share price as the market prices in the risks associated with maturity.

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“If a company does not have the liquidity to settle or the ability to refinance their convertible debentures then they may be forced to repay the holders through the contractual conversion of the debentures to equity, which [as prices continue to drop] ... may cause significant dilution to existing shareholders.”

Debenture holders themselves sometimes intentionally drive prices down to maximize their earnings from interest payments and to make money from short selling, said Martin Landry, an analyst who covers the cannabis industry for GMP Securities.

Hedge funds, the main holders of convertible debt in the cannabis space, often use a risk-reduction strategy known as a “convertible hedge.” At the same time they’re buying a company’s debentures, they’re selling the company’s shares short, in an amount equal to the number of shares they would receive if they converted the debenture. If the price drops, they make money from the short sale, and earn interest payments from the debentures. If the stock goes up, they can close their short position with the shares from the debenture conversion.

Hedge funds holding debentures are therefore incentivized, at least some of the time, to keep a company’s stock price from increasing and the debentures from converting.

“We have seen that a little bit in my view with Organigram,” Mr. Landry said.

The New Brunswick-based cannabis grower was able to force the conversion of $98-million worth of debentures in February after its stock rose above $7.05 per share for 10 consecutive trading days. Organigram’s stock had nearly breached that threshold twice before, in October, 2018, and again in December.

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“Every time it got close [to staying above $7.05 for 10 straight days], the stock would get crushed,” Mr. Landry said. “My issue with convertible debentures is more the stock manipulation it can trigger.”

When Organigram raised money in 2017, convertible debentures were one of only a few financing options available, said the company’s CEO Greg Engel.

“Where we are now though, [convertible debentures] are not the preferred way for us to raise money,” he said. “We have access to traditional bank debt financing... and we are certainly discussing with the Canadian banks to do something along those lines [since] it is cheaper and means less volatility in terms of potentially getting our shares shorted by some hedge fund.”

Traditional debt is becoming available to top-performing LPs – those with significant physical assets and actual revenue flows, against which mainstream banks can lend. Many smaller cannabis firms, however, continue to rely on increasingly risky debenture deals.

In February, for instance, Wayland Group Corp. (formerly called Maricann Group Inc.) agreed to raise up to $20-million, in five tranches, from a fund managed by U.K. lender Alpha Blue Ocean, using a particularly risky type of debenture.

Rather than the debentures converting into Wayland shares at a fixed price, the conversion ratio for the debentures shifts depending on Wayland’s stock price. If Wayland’s share price declines, Alpha Blue will be able to convert each successive tranche of debentures into ever more shares, compounding share dilution and corresponding price declines.

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That’s on top of roughly $16-million worth of convertible debentures, still on Wayland’s books (as of its most recent financial statements) from a previous financing round. These debentures, which carry a 9-per-cent interest rate, mature in October, 2020.

Companies that are hoping to escape debt burdens by being acquired are likely out of luck, said Mr. Taylor of Purpose Investments. The appetite for acquiring smaller LPs – even for bargain-basement valuations – appears to be waning.

“We are hearing that a lot from the big Canadian companies, Canopy Growth, for example, has been on the record about saying they’ve bought all they really want to buy in Canada and are not looking to add any more here and want to buy internationally,” Mr. Taylor said.

“And if that is the case, then a lot of these mid-tier Canadian cannabis companies with convertible debt are in a bad position.”

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